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Why Surging Stocks May Not Mean the Economy Trusts Trump

Via The New York Times : The early stock market reaction to Donald J. Trump’s election victory was overwhelmingly positive. But that doesn’t mean a Trump presidency will be good for the economy.

Stock markets often serve as an economic scoreboard: Increasing stock prices are equated with economic victory. But these inferences are too facile, because some increases connote good news, while others do not.

Reading market movements — such as the steep rise in stock prices in the early postelection days, as well as the subsequent ups and downs — requires a Rosetta stone. Constructing one takes an understanding of what drives stock prices and how that relates to the overall health of the economy.

Buying stock in a company entitles the owner to a percentage of present and future profits. The share price should be equivalent to a prediction of what these future profits will be.

That’s the theory, anyway, and stock markets, when they work, excel because these stocks are traded assets and all traders can contribute to the market’s overall prediction. If traders feel stock prices are low relative to future profits, they will bid up prices; if they feel prices are high, they will sell and drive down prices. In this way, the final price represents a collective prediction by the entire market.

An increase in stock prices therefore signals an expected increase in future profits. The movement in stock prices has a direct effect: Shareholders are immediately wealthier. Anyone holding a retirement portfolio knows the all-too-familiar feeling of reading stock price movements through the narrow lens of how well you can retire. This does not benefit all people in the economy — some shares are held by citizens of other countries, and the shares held in this country are not equitably held — but at the least, a surge in stock prices equals more wealth for the citizenry.

But rising stock prices can spell good news for other reasons: Even many of those who do not own stocks can expect a brighter future. This is because when companies prosper, consumers frequently also do well. This notion can be somewhat counterintuitive. After all, we often reflexively assume that when businesses make more money, they do so at our expense, that is, by overcharging us.

In a well-functioning market, though, the interests of companies and consumers are aligned. Businesses profit when customers enthusiastically buy their products: Higher profits mean happier customers. The economy as a whole is doing well.

By way of example, suppose Apple unveils a new iPhone that buoys its stock price. Traders are bullish about the iPhone’s robust sales. They are focused on the fact that these sales add to Apple’s coffers. But each sale, assuming consumers are choosing wisely, is also presumably producing joy for consumers.

This example also makes clear when the stock market can be a poor scoreboard for the economy. Sometimes companies can profit without improving consumers’ lives, or possibly even by worsening them.

For example, part of the stock surge after the election most likely occurred because of a widely held belief that a Trump administration would slash regulations. That may be good for some companies’ bottom lines, but is that good for everyone else? It depends. Do those regulations hinder only products that were profitable and good for consumers? Or do they also hinder products that are bad for consumers?

Take the case of Wells Fargo, which was recently found to have created millions of accounts in customers’ names without their knowledge. These accounts were profitable for Wells Fargo, but surely not good for consumers.

The extent of this behavior was uncovered because of the work of a regulatory watchdog: the Consumer Financial Protection Bureau. Mr. Trump’s election increases the possibility that the bureau will be shut down or that its powers will be curtailed. But if this prospect raises the value of bank stocks because it makes it more likely that behavior like Wells Fargo’s can flourish, that’s hardly cause for celebration. And it’s not good news for the economy.

In short, whether a rise in stock prices is good or bad for nonshareholders depends on whether the increase in profits arises because companies are serving consumers or because they are profiting at consumers’ expense.

There is a final factor to consider: The capacity of traders to make predictions about future profits is limited.

In 1997, Michael Rashes, then a doctoral student in economics at Harvard and now a principal at Bracebridge Capital, noticed something funny about stock prices. On Oct. 1, WorldCom made a bid for MCI Communications. Shares listed under the symbol MCI went up that day. In itself, that wasn’t surprising: Good news raises prices.

The problem, as Mr. Rashes noted, was that the ticker symbol MCI belonged to Massmutual Corporate Investors. This fund had nothing to do with MCI Communications, which traded under the ticker symbol MCIC. His paper was published in The Journal of Finance in 2001, under the title “Massively Confused Investors Making Conspicuously Ignorant Choices (MCI-MCIC)”.

This was not a freak event: Traders are highly fallible. On Oct. 4, 2013, for example, after Twitter announced its initial public offering, the stock price of the Boston-based consumer electronics chain Tweeter, which had filed for bankruptcy in 2007, rose to 15 cents a share from the previous day’s close of less than 1 cent. Trading was eventually halted.

A large body of research now emphasizes a basic fact: Despite the rise of computers and artificial intelligence, markets are, at their root, made up of human traders. Yes, the crowd is often smarter than the individual. But smarter does not mean perfect. Many of the biases of individual traders become broader market biases. In fact, some new biases are introduced when traders feed off one another and compound their mistakes.

On election night, the votes at the ballot box mattered. In the financial markets, another kind of vote counting took place. Just as the presidential election tells us only who voters believe is good for the country, the market can tell us only what traders believe is good for a company’s bottom line.

It is an all-too-familiar adage that democracy is the weakest form of government, except for all the others. Similarly, stock markets are the weakest way to predict the future, except for all the others.
Correction: November 18, 2016

An earlier version of this article misstated the rise in shares listed under the symbol MCI related to investor confusion over a similar stock symbol (MCIC). The shares in MCI rose 2.35 percent on Oct. 1, 1997, not 18.56 percent.
Correction: November 18, 2016

An earlier version of this article erroneously attributed a distinction to the Consumer Financial Protection Bureau. While the agency discovered the extent of the fraudulent accounts at Wells Fargo, it was not the first to uncover the activity.

SENDHIL MULLAINATHAN is a professor of economics at Harvard.

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THE NEW YORK TIMES | Why Surging Stocks May Not Mean the Economy Trusts Trump

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